Let your DH find out for himself who his daughter is - you protect yourself, your daughter and your home. He can see her outside the home, but no visits to the home, no holiday plans with her, no money sent her way, etc.  You and DD don't have anything to do with her unless it's shown that she's more stable.

I understand where DH is coming from, but she's toxic and he will find that out on his own.

I agree.  You need to throw up STRONG boundaries.  He is welcome to see his daughter elsewhere, not in your home because you don't want the chaos...not that you don't like HER.  It's important that you frame it that way.  I'm guessing your finances are joint?  Please keep an eye on them.

My SO also has a daughter who doesn't exercise good judgment and is currently dating a 5 time felon.  She has one kid and I hope and pray she doesn't have any more.  My SO also gets sucked in by her.  Due to her somewhat recent drug dealing charges I don't want her in our home.  Of course my DH is fine with that but misses having his child and grandchild coming to visit our farm and seeing the animals.  Too bad.  Our finances are separated so who knows what he's doing there...

My condolences on the loss of your grandchild.  What a nightmare.

This is NOT about you in any way. It's classic SD/BM stuff that we see repeatedly, with the SM making the easiest target for blame because she's outside the Failed First Family. It's THEIR garbage, so don't let the stench of it affect you or your bio because it has nothing to do with you.

You have clarity, and are spot on in your assessment. It seems your DH has backslid a bit and is looking for something he isn't going to get. This is common with guilty parents, as time can soften harsh reality. You know it, I know it, even your daughter knows it, but perhaps he needs a fresh dose of poison to wipe away the delusion. I know it can feel unsettling, but remember - you get to decide who you allow into your life, so even if there is a miraculous reunion (lol) you don't have to be involved. Your DH can see his pos daughter elsewhere, and compartmentalize his relationships.

I recommend focusing on maintaining what's good and healthy while your DH is on his fool's errand. Remain neutral and calm when the topic of SD comes up; if pressed to engage with her, just state that she's hurt you deeply and you're not ready to do so at this time. Assume a bit of victim status - don't let SD have it all. Make your home a comfortable, peaceful sanctuary - after an a$$ chewing blamefest with toxic SD, your DH is more likely to appreciate how well adjusted his life with you is. 

As long as he's not funding SD or bringing the garbage into your marriage, try not to give it space in your head. Even if SD tries using the gskids as bait, without your help (and since SD doesn't like you, you wouldn't want to upset her by helping with the gskids, right? wink wink), your DH will soon get tired of doing it on his own. Odds are, he'll get a harsh reminder of who and what his daughter is, and retreat to a safe distance.

((((HUGS))))))

Welcome to Step Talk---

Surviving (and even thriving) in a dysfunctional steplife requires that you be able to create boundaries, set limits, and not get sucked into what is not really your business.The primary relationship is the father-daughter one; you are thankfully only peripheral. Competition for resources is real, but you need to position yourself so that it's SD causing discomfort by stirring up drama, not you imposing restrictions and pressure.

You tried being inclusive, but SD rejected that, which is actually your Golden Ticket out of the poo. Your DH might want you to offer yourself up again, but that's only because it would make things easier for HIM. You can pay lip service by telling him "DH, you know SD isn't interested in a relationship with me or DD, and I don't want to jeopardize your efforts with her by interfering. You go ahead."  You know the truth, even if your DH doesn't, so play the supportive wife while protecting yourself from his folly.

Years ago I got a great piece of validation from, of all things, the tv show Grey's Anatomy. A doctor who had escaped a rough childhood and worked his butt off to rise and create a good life for himself is confronted at the hospital by his younger brother, a poor blue collar guy who's still steeped in the family dysfunction. The brother wants the doctor to come back home to help with their crazy mother. The doctor gestures around him in a manner that emcompasses his work, his friends, and his life, saying  "Look - I can have THIS (looks around), or I can have THAT (his crazy family). But I can't have both." 

That scene gave me permission to stop trying and start prioritizing my own needs. It made me see that we sometimes have to make hard choices in order to be healthy - and that it's okay. You're doing what you're supposed to, within your circle of responsibility, and that is smart.

Make sure you/your husband have iron clad wills in place....