1. What file system should I use on my USB Drives?
Depends on how you are going to be using it. USB drives come formatted FAT32. If all you are going to be using it for is backup to SME, then I'd recommend reformatting to ext3. FAT32 is not a reliable file system and SME does not support NTFS.
2. Do I need to manually mount and unmount the drives when I change them over?
Yes and no. SME will automatically create an fstab entry for each USB drive at /media/usbdisk1 (2,3,...,x) This mount point will need to be manually mounted. However, you can create another mount point for the usb disk and make an entry in fstab and SME will automatically mount it at bootup. Technically, you should unmount the drive prior to unplugging it to avoid data loss/corruption.
3. I have two (2) external USB Drives, apart from doing a full backup every night and rotating the drives, what other options should I consider.
Depends on the drive sizes. If you can keep a few weeks worth of nightly backups on your drives with one off-site at any given time, then you are pretty safe. However, I'm not a backup guru.
Perhaps someone like Shad or Darrell May could chim in here. I know Darrell did quite alot of work documenting USB drive backup when he started the Dar2 project. You should try searching the forums and the devinfo mailing list.
One final note: USB disks are an OK backup solution, but use them with caution. They are much more prone to failure than an internal drive due to the heat generated by the drives. NEVER rely on a single USB drive as your only fallback. Make sure you have at least two.