Why do we use a Yad when reading Torah? In general, why is it prohibited to touch the torah directly?
You have actually answered your first question by asking your second question. A Yad is used in order to show the Oleh (the one who was called to the Torah) the place as the reader reads the Torah. Since one may not touch the Torah directly, and therefore the reader’s actual finger may not be used for this purpose, the custom developed to use a Yad. However, there is no requirement to use a Yad and a reader may choose to show the Oleh the place with his finger hovering over the Torah making sure not to touch the Torah directly.
As far as you second question, the easy answer is that the law prohibits one from touching the Torah directly. This law can be found in the Shulchan Aruch Chapter 147, section 1 and is derived from the Talmud, tractate Megilla 32a.
The most basic reason for this law is to develop a respect and awe for the Torah, handling a Torah scroll in a different way we would handle any other book. The care with which we are to handle a Torah makes us aware of its special status as our guide for life and blueprint of the universe.
The Maharal offers a fascinating alternative approach to understading this law. Although man is composed of a spiritual side (his soul) and a physical side (his body), in this physical world, the soul is completely obscured by the body. The soul certainly exists, but cannot show itself in this world of physicality. Our senses and this realm of reality would not be able to handle it, so awesome is the power of the soul. Spirituality cannot be exposed in this world of the physical. Therefore, the Torah, the epitomy of spirituality also cannot be exposed to the naked touch of our physical bodies—it is both improper and almost insulting to the Torah. The Torah must be cloaked by some other item, as all spirituality is, before coming in contact with the physical reality of our world.
Hope this helps clears things up and provides some food for thought.
Rabbi Yoel Spotts