1) It is to adjust the frequency cutoff of the sound the sub plays. Bypass means there is no cutoff and it plays as high as the sub will go.
2) Depends on your setup. If using an AVR with bass management, it should be set at its highest setting or you should be using bypass. If you do not have bass management, you'll want an SPL meter and test tones to properly adjust this setting to blend with your system.