Is this a valid statement about Identity Security Cloud sign-in methods?

No. The term Directory Connection does not mean that Identity Security Cloud reads authentication credentials from an encrypted file stored in a filesystem directory. Directory Connection is SailPoint's pass-through authentication mechanism. For an identity profile configured with this sign-in method, administrators select an aggregated authentication source that corresponds to the identities in that profile. Users then authenticate by using the network password associated with their account on that source.

During authentication, Identity Security Cloud relies on the configured external directory source to validate the user's credentials. This is particularly common with enterprise directory systems such as Active Directory. The mechanism therefore enables users to use their organizational network credentials rather than maintaining an independent Identity Security Cloud password.

A prerequisite is that the authentication source and relevant accounts have been aggregated. An identity must also have an appropriately correlated account on the configured authentication source; otherwise authentication-source mismatch errors can occur.

No encrypted credential file in a local folder forms part of the documented Directory Connection authentication architecture.

Study Guide Reference: Access Management — Sign-In Methods, Directory Connection, Pass-Through Authentication and Authentication Sources.