From what I've been told we can setup SSH Key pairs to authenticate between client and Marketing Cloud SFTP server. Can we setup SSH Key authentication between Marketing Cloud and an External SFTP server? (the external server will generate the keys).
Yes you can.
You would first create the key (the one for SFMC to use, not the actual SSH key) under 'Key Management' in admin selecting the SSH option (talk to your AE if you do not have this option on your account.
You then select the 'location type' as 'External SFTP Site' and change 'Auth Type' to 'Auth Key' and then select the corresponding 'Auth Key' that you just made in 'Key Management'.
That should then allow you to access your SFTP via SSH Key.
1As an update: all of the above is still correct, except you no longer have to talk to SF: Enabling SSH for your SFTP has become self-service recently. You can find an option under Setup / FTP Accounts, click the little arrow icon next to the account and you can enable SSH + configure whether password access will still be possible. Jul 30, 2020 at 14:47